The Economic Truth

January 4, 2024 marks the expiration of the "three year derogation from margin rules in respect of non centrally cleared over-the-counter (OTC) derivatives, which are single-stock equity options or index options, in the EU. <oof.gif> ----- Let's provide some background, shall we?? "Single stock equity options and index equity options (‘equity options’) play a significant part in the real economy. Imposing variation and initial margin requirements on these instruments would increase funding costs and operational complexity and could result in smaller EU counterparties ceasing to use equity options for hedging and risk mitigation purposes. In addition, given some major jurisdictions (e.g. the US) are permanently exempting equity options from margin requirements, EU market participants would face a clear competitive disadvantage when dealing with non EU counterparties. Given the very small size of the equity option market compared to the overall OTC derivatives market and also the short maturities of such instruments, a permanent exemption from margin requirements would not add material risks to financial stability". "In the U.S., equity options are not in scope of Title VII of the Dodd Frank Act and there is therefore no prospect of these contracts being subject to the US margin rules". As such, smaller [EU] counterparties will be disproportionately impacted if margin requirements for equity options were imposed upon them. "Article 38 of the [European Market Infrastructure Regulation (EMIR)] Margin [Regulatory Technical Standards] RTS provides for a derogation until 4 January 2024 from the variation and initial margin obligation in respect of all non-centrally cleared OTC derivatives which are single-stock equity options and index equity options (‘equity options’). This temporary derogation was introduced to avoid market fragmentation and to ensure a level playing field for EU counterparties on a global level, given many jurisdictions either have not implemented margin requirements for equity options (US, Singapore) or have also introduced temporary derogations (Hong Kong, Switzerland, South Korea, UK) for these contracts." Let's make some quick sense of all this word soup, shall we... Because the U.S. does not view equity options as being in scope for Title VII of the Dodd Frank Act, single stock equity options and index equity options are not subject to U.S. margin rules. (convenient!) Understandably, this does not sit well with EU, as they did not initially have this same exemption on equity options. So, as to not fragment markets, ensure a level playing field for EU, and align with the US to avoid disruption of cross-border business, EMIR Margin RTS provided an exemption from margin requirements on "all non-centrally cleared OTC derivatives which are equity options" until January 4, 2024. In the mean time, EU is still fighting for a permanent exemption, to align with their U.S.jurisdictional counterpart. This exemption was adopted to remove the obligation of variation and initial margin requirements on EU counterparties in conjunction with the once average aggregate notional amounts (AANA) on derivatives transactions exceeded the €8 billion threshold. Essentially, counterparties that are in-scope of UMR Phase 6 uncleared margin rules will exchange initial margin once their AANA is exceeded. (We recently discussed initial margin and AANA in more detail, here: teapaw.org/McSqueezyTheCow/status…) Before we wrap up... I thought I'd share something I find comical in all of this; ISDA's and EU's downplaying of the size of equity options market in contrast to the overall OTC derivatives market. "...most of these contracts have a short maturity" "The impact on financial stability of exempting these contracts from the Margin RTS is...marginal" "According to BIS data, equity options represented 0.55% of notional amount outstanding of all OTC derivative contracts in H1 2022" Translation: Providing the EU with an exemption on equity options is a nothing-burger. The maturities are short and the impact will be marginal. In fact, it's so much of a nothing-burger, that in the first half of 2022, equity options only accounted for 0.55% of all OTC derivative contracts. --- But what they're also not saying is in the first half of 2022, that 'only 0.55% of equity options' was actually $3.477 trillion in notional value. And the value of all OTC derivatives contracts in the first half of 2022?? $632.113 trillion! (See the orange squares in the above screenshot). --- And the value of OTC equity options in the first half of 2023? $305 billion. (See the red square in the above screenshot). Now, you may be thinking "That's not so bad, Squeezy", but is it really? It's only $305 billion" But before you celebrate or breathe a sigh of relief, let's quickly recall that "many jurisdictions either have not implemented margin requirements for equity options or have also introduced temporary derogations". Additionally, we are only talking about a very small subset of OTC derivatives; equity options. There still exists a myriad of securitized instruments that are gambled on well into the trillions, beyond what any individual [or pair of] counterparty [ies] can afford or de-lever. Translation: The majority of jurisdictions that take part in OTC derivatives do not have equity options as being in scope of margin rules. Observation: How big of a flaming bag of leveraged excrement is the OTC derivative market on single stock equity options and index equity options (‘equity options’) if the majority of jurisdictions are not even paying attention to it because of either permanent or temporary exemptions?!?! And what happens to jurisdictions when these derogations [exemptions] expire?? And what happens when a jurisdictional counterparty defaults or suffers a significant enough credit event or market shock?!?! <elmofire.gif> ----- TLDR: EU participants in the OTC derivatives market were given an exemption on margin rules [initial and variation margin] on equity options. This exemption is currently scheduled to end on January 4, 2024. ----- What's more?? EU's derogation that is set to expire is only applicable to non-centrally cleared OTC derivatives. Per Investopedia, "A central counterparty clearing house (CCP) is an organization, usually operated by a major bank" that "acts as a counterparty to both sellers and buyers, collecting money from each, which allows it to guarantee the terms of a trade" ----- Why is this important?? CCP's: • Shield the associated traders’ identities from one another • Protect trading firms against default from buyers and sellers who are matched by an electronic order book and whose creditworthiness is unknown • Reduce the number of transactions that are being settled ----- TLDR²: EU is participating in leveraged bets [OTC derivatives] in a market that is off-exchange, and as such, subject to less oversight and regulation [OTC market]--not that regulated markets have much oversight in the first place--and is doing so without additional protection from default [central clearing]. ...and their exemption on margin requirements is set to expire in a month. Unless extended, things may be escalating rather quickly. ----- Tick MF'n TOCK! ----- #SystemicRisk #EuropeanUnion #Derivatives #OTC #RiskyBusiness #WallStreet #BankCrisis #Options #MarginRequirements #MarginCall #Collateral #LiquidityCrisis ISDA - Updated OTC Derivatives Compliance Calendar 2023-12-1: isda.org/a/RCqgE/Updated-OTC… ISDA - ISDA Comments on EMIR 3 Package - February 2023: isda.org/a/a6ygE/ISDA-commen… Official Journal of the European Union - Commission Delegated Regulation (EU) 2021/236 of 21 December 2020 - Amending Technical Standards Laid Down in Delegated Regulation (EU) 2016/2251 as Regards to the Timing of When Certain Risk Management Procedures Will Start to Apply for the Purpose of the Exchange of Collateral: eur-lex.europa.eu/legal-cont… ISDA - Exemption From the Margin Requirements for Single Stock Equity Options and Index Equity Options: isda.org/a/9BygE/Joint-trade… Bank for International Settlements (BIS) - Global OTC Derivatives Market: stats.bis.org/statx/srs/tabl… Investopedia - Central Counterparty Clearing House (CCP): investopedia.com/terms/c/ccp…